Wednesday, March 18, 2009

Are Debt Consolidation Loans Good For The Long Term?

The answer to whether or not debt consolidation loans can have a long term benefit to your financial health is not as simple as it may seem. Those who dislike this financial instrument will decry debt consolidation as a band aid on a gushing wound. They suggest that this type of loan lulls those who take it into a false sense of security - the debt isn't really gone, it is still there and growing.

Then there are others who would suggest that taking out this type of loan can really help individuals (whether they be Christian or non-Christian, military or civilian, a student or a company) who are being crushed by debt to make a little breathing space so that they can focus some energy on preventing the acquisition of new debt on top of the old. How can somebody be expected to pay large sums of their salaries to their creditors and still survive? The cash flow crisis is what needs to be attended to in this circumstance.

The truth about debt consolidation loans is that both groups are 100% correct depending on your own unique set of circumstances. No two people are going to answer the question posed in the title of this post the same way because the long term benefit of debt consolidation is really not that cut and dry.

A few examples are always helpful in a situation like this. When is consolidation good in the long term and when is it bad in the long term? Let's take a look.

Bad Long Term Debt Consolidation Loans
A bad consolidation loan is going to be one where you needlessly pay out more money to your creditors than is absolutely necessary. You see, the truth about this type of instrument is that it will reduce the amount of your monthly payment by decreasing the interest rate on the loan and increasing the amount of time, or term, it takes to pay back the loan.

However, this reduction in the interest rate and increasing of the term of the loan has the unfortunate side effect of increasing the amount of money you pay to your creditors over the life of the loan. I have explained this in greater detail in another post where I talk about types of information you need when considering a debt consolidation loan.

The basic gist of it is this - the more time that interest is able to accumulate in your account the more likely you are to pay more to the bank. This is not good and is definitely the situation that you want to avoid - especially if you can currently handle your monthly payment.

Unless you are extremely pressed for cash flow, the best thing that you could do in a situation where you know your debt is an issue to cut down on expenses and simplify. Getting debt free is a lot of work and requires some serious sacrifices. Do you eat out a lot? Stop and start making your lunches and bringing them to work. The $5-10 a day that you save can help you pay off a little bit more of your credit card each month.

Are you a Starbucks addicts? Do you rent a lot of movies or see them in the theaters? Is the library a foreign word to you? Are TV shows really that much better on cable where it costs hundreds of dollars a year compared to watching them for free on Hulu or the networks website? Is soda really that important for you to drink everyday? There are literally tons of ways that many, many Americans facing crippling debt can adjust their lifestyle to better eliminate it from their lives.

You know that an extra $100-$200 a month could really help pay off your credit cards faster, right? For every extra $100 you can send to a debt with at 7% interest rate you will end up saving 58 cents a month. You might go, "That doesn't sound like very much. Why would I accelerate my debt payments?"

Here is the answer: if you can find an extra $100 a month you will pay off a $20,000 loan with a 5 year term and 7% interest rate in 47 months instead of 60 and end up saving $893. That is some pretty significant savings when you add it all up. If you can find $200 extra a month then your debt will be gone in 37 months and you will save over $1,4oo in debt payments. I am telling you, the little things add up when dealing with paying off your creditors!

So if you have sufficient cash flow to stay away from acquiring more debt, then a debt consolidation loan is probably not going to be in your best interest. You are better served with making some tough life style decisions and getting over your need to constantly be entertained. Simplify your life and reduce your expenses already! Then use that extra cash to pay down your debt more aggressively.

You can even employ one of the different versions of the debt snowball to get things rolling in your favor. Getting out of debt is sometimes more about psychology than it is about finances, so make the mental game just as important as some of the more 'practical' steps that you need to take.

Good Long Term Debt Consolidation Loans
Now that we have gotten out of the way the situation where a consolidation loan will actually be bad for you in the long term let's take a look at how these financial instruments can be useful in the long term. I have mentioned it above as well as in other posts - dedt consolidation loans are only really useful when you have a very serious cash flow crisis.

What do I mean by a "very serious cash flow crisis?" Well, whenever your expenses exceed your income I would call that a cash flow crisis. A very serious cash flow crisis is when a person's expenses exceeds both their income and their savings. This means that not only is a person not able to pay their way with their paycheck, they aren't even able to pay their way with their savings!

This type of person is a prime candidate for acquiring more and more debt. The more that they acquire, the less likely that they are able to pay off their old debts and the greater the strain becomes on their cash flow situation (since there debt payments are taking up an increasingly larger portion of their take home pay because they are forced to take on new debts every month).

At the very least, this individual is inching forward on the road to debt freedom. For every two steps they take forward on the road to repayment, they are driven one step back by having to take on new obligations.

This type of person could be a good candidate for a debt consolidation loan since it will have long term positive impact on their finances. They can escape the cycle of debt by reducing their monthly payment and freeing up some cash to begin saving for emergency expenses (like car repair, medical bills, urgent home repair, etc). Then, once they have some financial stability in their life, they can focus on ending the lifestyle that lead the the mountains of debt that led up to this situation.

They can apply all the tricks to their life to cut expenses and increase income, but they needed to establish some breathing room first so that they could stop the cycle of taking on new debt obligations. It doesn't matter if it is a secured or unsecured debt consolidation loan - heck, it might not even matter if they get the best interest rate around - what does matter is that they get a handle on their cash flow.

The long term impact of a debt consolidation depends largely upon the circumstance of the individual, so get informed about what will be best for you and your family.

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